The Hard Way

The quarter has come to an end
And Brexit’s now just round the bend
Meanwhile Chairman Jay
Has learned the hard way
Experience is his best friend

It has been more than a week and the market continues to talk about the liquidity crunch that drove repo rates to 10.0% briefly. The Fed did respond, albeit somewhat slowly, and have seemingly been able to get things under control at this point. But in the WSJ this weekend there was a very interesting article asking, how could this have happened? After all, the Fed’s primary responsibility is to ensure that there is sufficient funding in the system. And I think for all market participants, this is a critical question. Since the Fed is essentially the world’s central bank, if they are losing control of the plumbing of the US money markets, what does that say about their ability to implement monetary policy effectively.

The back story revolves around actions that occurred shortly after John Williams was named NY Fed President, despite a complete lack of markets experience (he is a PhD Economist and Fed lifer, never having held a job in the private sector). In one of his first acts, he dismissed two key lieutenants, the head of the Markets Desk and the head of Financial Services, both of whom had been with the Fed for more than twenty years, and both of whom had intimate familiarity with market crises. After all, they were both in their roles during the Financial crisis, when Williams was one of a hundred economists working for the Fed’s Board of Governors. In other words, he has zero real world or market experience, and he fired the two most experienced market hands in his organization. While there has never been an explanation as to why he made that move, it clearly came back to haunt him, and the Fed at large, last week.

The issue for markets is now one of confidence. It doesn’t matter that things seem to be under control at this point, and all the talk of a standing repo facility being implemented to insure there is always sufficient liquidity are addressing the symptoms, not the cause. In addition, there is almost no question that the Fed is going to start rebuilding its balance sheet, as apparently, watching that paint dry was a bit more exciting than anticipated. But in the end, if market participants lose faith that the Fed can effectively manage its processes, then it will significantly change the overall atmosphere in markets. Remember, we have spent the last ten plus years being taught that central banks, and the Fed in particular, have one job, to protect financial markets. Two weeks ago, we realized that the ECB has basically run out of ammunition in its efforts to continue to address Europe’s problems. If the Fed has lost the knowhow regarding what is needed to manage the US financial system, that is a MUCH larger problem. I’m not saying they have, just that the repo market gyrations are an indication that they will have to work very hard to convince markets they are still in charge.

Turning to the market situation overnight, there has been very little of interest overall. In fact, the best way to describe things would be mixed. For example, the dollar is slightly firmer vs. the euro (+0.15%) but slightly weaker vs the pound (-0.15%). And the truth is, as I look across the board, that is a pretty good description of the entire FX market, modest gains and losses without any trend to note. European equity markets are little changed, US futures are the same and Asian markets were mixed (Nikkei -0.5%, Hang Seng +0.5%). Finally, bond markets have shown almost no movement with 10-year yields in the major bonds within 1 basis point of Friday’s levels.

As today is quarter end, it feels like most market participants have already straightened up their positions and are waiting for tomorrow to start anew. Meanwhile, we have seen a bunch of data, with the most noteworthy so far being the very slightly better than expected Chinese PMI data, with Manufacturing PMI printing at 49.8 vs. expectations at 49.6. So, while that is better than a further decline, it still points to contraction and slowing growth in China.

Looking ahead to today’s session and the week upcoming, though, there is a lot of new information on the way, including the payroll report on Friday.

Today Chicago PMI 50.0
Tuesday ISM Manufacturing 51.0
  ISM Prices Paid 50.5
Wednesday ADP Employment 140K
Thursday Initial Claims 215K
  Factory Orders -0.3%
  ISM Non-Manufacturing 55.1
Friday Nonfarm Payrolls 146K
  Private Payrolls 130K
  Manufacturing Payrolls 3K
  Unemployment Rate 3.7%
  Average Hourly Earnings 0.3% (3.2% Y/Y)
  Average Weekly Hours 34.4
  Participation Rate 63.2%
  Trade Balance -$54.5B

In addition to the payroll report, we have fourteen Fed speakers, essentially the entire FOMC, this week. My conclusion from this excessive schedule is that the Fed is very concerned that their message is not getting across effectively and that they feel compelled to clarify and repeat the message. However, given the wide disparity of opinions on the Board, my sense is this onslaught of speeches will simply add to the confusion. Chairman Powell has a tough road ahead to get his views accepted given what seem to be hardening positions on both sides of the argument. In fact, the only way the doves can win out, in my view, is if the economic data here starts to deteriorate significantly, but of course, that is not an outcome they seek either!

As to the dollar, there is nothing that has occurred anywhere to dissuade me from my ongoing bullish view. Until we see some more significant changes in the data, the dollar will remain top dog.

Good luck
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The Question at Hand

There is an old banker named Jay
Who’ll cut Fed Funds later today
The question at hand
Is, are more cuts planned?
Or is this the last one he’ll weigh?

Well, no one can describe the current market situation as dull, that’s for sure! The front burner is full of stories but let’s start with the biggest, the FOMC announcement and Chairman Powell’s press conference this afternoon. As of now, futures markets are fully pricing in a 25bp cut this afternoon, with a small probability (~18%) of a 50bp cut. They are also pricing in a 50% chance of a cut at the October meeting, so despite the hawkish rhetoric and relatively strong data we have seen lately, the doves are keeping the faith. In fact, it would be shocking if they don’t cut by 25bps, although I also expect the two regional Fed presidents (George and Rosengren) who dissented last time to do so again. What has become clear is that there is no overriding view on the committee. The dot plot can be interesting as well, as given there are only two meetings left this year, it will give a much better view of policy preferences. My guess is it will be split pretty evenly between one more cut and no more cuts.

Then it’s all on Chairman Jay to explain the policy thinking of the FOMC in such a way that the market accepts the outcome as reasonable, which translates into no large moves in equity or bond markets during or after the press conference. While, when he was appointed I had great hopes for his plain spoken comments, I am far less confident he will deliver the goods on this issue. Of course, I have no idea which way he will lean, so cannot even guess how the market will react.

But there’s another issue at the Fed, one that is being described as technical in nature and not policy driven. Yesterday saw a surge in the price of overnight money in the repo market which forced the Fed to execute $53 billion of repurchase agreements to inject cash into the system. It turns out that the combination of corporate tax payments in September (removing excess funds from the banking system and sending them to the Treasury) and the significant net new Treasury issuance last week that settles this week, also in excess of $50 billion, removed all the excess cash reserves from the banking system. As banks sought to continue to manage their ordinary business and transactions, they were forced to pay up significantly (the repo rate touched 10% at one point) for those funds. This forced the Fed to execute those repos, although it did not go off smoothly as their first attempt resulted in a broken system. However, they fixed things and injected the funds, and then promised to inject up to another $75 billion this morning through a second repo transaction.

It seems that the Fed’s attempt at normalizing their balance sheet (you remember the run-off) resulted in a significant drawdown in bank excess reserves, which are estimated to have fallen from $2.8 trillion at their peak, to ‘just’ $1.0 trillion now. There are a number of economists who are now expecting the Fed to begin growing the balance sheet again, as a way to prevent something like this happening again in the future. Of course, the question is, will this be considered a restarting of QE, regardless of how the Fed tries to spin the decision? Certainly I expect the market doves and equity bulls to try to spin it that way!

Ultimately, I think this just shows that the Fed and, truly, all central banks are losing control of a process they once felt they owned. As I have written before, at some point the market is going to start ignoring their actions, or even moving against them. Last week the market showed that the ECB has run out of ammunition. Can the same be said about Powell and friends?

Moving on to other key stories, oil prices tumbled ~6% yesterday as Saudi Arabia announced that 41% of their production was back on line and they expected full recovery by the end of the month. While oil is still higher than before the attacks, I anticipate it will drift lower as traders there turn their collective focus back toward shrinking growth and the potential for a global recession. Chinese data continues to look awful, Eurozone data remains ‘meh’ and last night Tokyo informed us that their trade statistics continued to deteriorate as well, with exports falling 8.2%, extending a nearly year-long trend of shrinking exports. The point is, if the global economy continues to slow, demand for oil will slow as well, reducing price pressures quite handily. In a direct response to the declining oil price we have seen NOK fall 0.5% this morning, although other traditional petrocurrencies (MXN, RUB) have shown much less movement.

On the Brexit story, Boris met with European Commission President, Jean-Claude Juncker on Monday, and while he spun the meeting as positive, Juncker was a little less optimistic. His quote was the risk of a no-deal Brexit was now “palpable” while the EU’s chief Brexit negotiator, Michel Barnier, said, “nobody should underestimate the damage of a no-deal Brexit.” It should be no surprise the pound fell after these comments, but that is a very different tone to yesterday’s NY session. Yesterday, we saw the pound rally more than a penny after word got out that the UK Supreme Court justices were ostensibly very skeptical toward the government’s argument and sympathetic to the plaintiffs. The market perception seems to be that a ruling against the government will essentially take a no-deal Brexit off the table, hence the rally, but that is certainly not this morning’s tale. In the end, the pound remains binary, with a deal of any sort resulting in a sharp rally, and a hard Brexit on Halloween, causing just the opposite. The UK hearings continue through tomorrow, and there is no official timeline as to when an opinion will be released. I expect the market will continue to follow these tidbits until the announcement is made. (And for what it’s worth, my sense is the Supremes will rule against the government as based on their biographies, they all voted remain!)

Finally, a look at the overnight data shows that UK inflation fell to its lowest level, 1.7%, since December 2016. With the BOE on tap for tomorrow, it beggars belief they will do anything, especially with Brexit uncertainty so high. At the same time, Eurozone inflation was confirmed at 1.0% (0.9% core), another blow to Signor Draghi’s attempts to boost that pesky number. As such, the euro, too, is under some pressure this morning, falling 0.25% after yesterday’s broad dollar sell-off. In fact, vs. the G10, the dollar is higher across the board, although vs. its EMG counterparts it is a much more mixed picture.

Ahead of the FOMC at 2:00 we see Housing Starts (exp 1250K) and Building Permits (1300K), but they will not excite with the Fed on tap. Equity markets are modestly higher in Europe though US futures are pointing slightly lower. Overall, barring something from the UK ahead of the Fed, I expect limited activity and then…

Good luck
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